Ignis: Death of deflation greatly exaggerated

Stuart Thomson, economist at Ignis Asset Management, comments: “Mark Twain is credited with the quotation: "reports of my death have been greatly exaggerated." The same may be said of deflation. Media interest is a great reverse indicator and news that the number of references to deflation in the last month has fallen to 19, the lowest monthly total since last September (the fateful month of Lehman's collapse) is bad news for the inflationistas. Inflation is seductive since if offers governments a relatively painless method to reduce their debt burden and over-indebted consumers and corporates of their future burden by penalising savings. However, Japan's internet-style depression, characterised as a www-shaped economic performance - or less charitably as an endless series of false dawns - is the product of the authorities' failure to drive up inflation expectations, and was caused by the lack of income to grow during the period. The charts below show earnings, consumer price inflation and the household savings rate in Japan from 1990 and illustrate the income deficit.

The chart shows that Japanese incomes continued to rise during the early stages of the nineties, enabling consumers to maintain their high savings rate and consumption, which in turn helped to cushion the corporate balance sheet recession and provided another bulwark to the economy alongside expansionary fiscal policy. It also helps explain why the authorities were slow to recognise the crisis. The slow moving train wreck of Japan's double decade disaster was driven by the lifetime employment system, which while by no means universal cocooned workers from the downturn at the expense of further deterioration of corporate balance sheets. The collapse of communist Eastern Europe and the emergence of India and China as well as the rest of Asia provided an extra billion workers for the global labour force, driving down the cost of labour. The first casualty of this intense downward pressure on labour costs were Asian currencies in 1997, but the collateral damage from this currency collapse forced Japanese corporations to address their balance sheet problems as the steep decline in exports provided the death knell for lifetime employment. Companies sought to lower labour costs by diversifying production abroad. The consequences of this jobs migration was initially mitigated by consumers running down their savings but eventually weak income was reflected in household consumption, inflation expectations and deflation.

Japan's harsh lesson has considerable resonance in the UK. The Governor in his Mansion House speech last week noted that that the path to full recovery will be protracted. This could prove to be optimistic. Mervyn King highlighted the fact that;"unlike previous recessions the crisis wasn't preceded by an unsustainable boom in output. In the five years leading up to the crisis, overall growth remained close to its long-run average and inflation differed from the 2% target on average by only 0.2 percentage points". Instead the catalyst for the crisis was excessive lending with the Governor underlining that the financial sector became too big and too highly leveraged; "the size of the financial sector as a proportion of GDP, five times that in the United States". The strange dichotomy between productive potential growth and rapid lending growth can be explained by weak current and potential income, which drove consumers to borrow heavily to maintain living standards.

This brings us to the crux of the debate over consumers' income deficiency. Consumers borrowed heavily during the noughties to maintain their living standards as real wages failed to keep pace with real economic activity and more importantly consumer income expectations. The average earnings chart shows that consumer income growth slowed during the decade despite above trend economic growth. Consumers' disappointment was not confined to current income expectations as the dismantling of corporate pension schemes also damaged permanent income expectations encouraging investment in residential property to compensate for the decline in prospective pension income. Employment growth was slow outside of the public sector, evident by the modest decline in the internationally recognised measure of unemployment, the ILO fell from 6% at the start of the decade to a low of 4.70% in August 2004 and the current rate of 7.20% is the highest since July 1997, just after the Labour Government's first election victory.

The government undoubtedly breathed a sign of relief at the smaller than expected increase in the claimant count unemployment increase of 39,300 during May. This was less than the consensus forecast of 60,000+ and the six monthly averages of 80,000 (including the outsized 140,000 rise in February). The ILO measure of employment, which is released with a lag declined by 232,000 in the three months to April to reach 2.26mn, the highest level since November 1996, while vacancies continued to decline as employment opportunities rapidly deteriorated. We continue to expect unemployment to rise further over the next few years to more than 3m, which in turn will push the unemployment rate above 10%. The rise in unemployment over the past three months has been smaller than expected because companies have been hoarding labour and cutting hours (see Alex Cartoon in today's Telegraph). Average hours have fallen at a record rate over this period. The result has been falling productivity and rising unit wage costs that have undoubtedly led to a desire to maintain margins and will have contributed to the higher than expected consumer price inflation.

This labour hoarding is not surprising given the sharp recovery in business confidence evident in the CIPS purchasing managers' indices for manufacturing and services. However, there is many a slip betwixt cup and lip. We believe that a great deal of hope and hype invested in these indices and the squeeze on corporate profitability will force companies to continue reducing employment. The rise in unemployment is likely to be long, slow and continuous. The main contributors to employment growth over the past decade have been the public sector, business services, finance and construction. Together these sectors contributed more than 80% of the employment growth over the period. We expect net employment in these sectors to deteriorate over the next five years. Support for this view is provided by the Centre for Economics and Business Research, which has forecast that business services will lose 311,000 jobs between 2008 and 2013. Employment in the sector is likely to be 8% lower from its 2008 peak. The CEBR expects output in the sector to fall by 5% this year and is unlikely to regain its previous peak by 2013.

This is a consequence of globalisation. Consumers in Western economies were able to compensate for the transfer of low value added jobs to developing economies by borrowing and increasing debt. However, over the next decade UK consumers will experience the dark side of globalisation as deflation spreads from Asia to the rest of the world. In particular, we expect wage growth to continue slowing as unemployment increases further over the next eighteen months as the output gap widens further to record levels. We expect nominal wages excluding bonuses to slow to less than 2% by the end of the year and remain in a 1-2% range throughout 2010 and could dip below 1% during 2011 when we expect the economy to dip back into recession as monetary and fiscal policy is tightened during the false dawn recovery in 2010. The latest CBI pay survey is consistent with this view with 60% of companies surveyed expecting to freeze salaries and recruitment. These wage rates will be less than inflation over the next eighteen months implying negative real incomes. The squeeze of real incomes will be compounded by tighter fiscal policy exaggerating the impact on real personal disposable incomes. The clear risk for the Monetary Policy Committee is that these lower pay awards become embedded in deflationary price expectations.

Public sector net borrowing widened to £19.9bn during May, compared to £12.2bn in May 2008, as tax revenues decreased by 11% and public spending increased by £7.4bn. Once again the deficit was higher than expected and is consistent with our forecast for the full fiscal year of £200bn rather than the Chancellor's optimistic estimate of £175bn. These are atrocious figures and cannot be allowed to persist regardless of Crash Gordon's Orwellian double speak about continued increases in health and education expenditure. The chorus of disapproval from the media over this blatant manipulation of the expenditure statistics shows that consumers are well aware of the Ricardian equivalence created by current record budget deficits in terms of future tax hikes and spending cuts. The resulting squeeze on real personal disposable incomes will make it extremely difficult for consumers to raise their savings rate in a painless fashion. The history of housing and financial recessions over the past three decades, including the UK examples of the early eighties and early nineties, shows that personal savings rates rise to more than 10%. This represents a doubling of the current rate of 4.8% over the next few years. This will be tough during a period of wage deflation.

Globalisation has driven down the cost of labour. Western economies compensated during the credit bubble by borrowing on a massive scale and relying upon asset price inflation to support employment in their economies. This is no longer possible in a post credit crunch environment. The most effective solution to this crisis will be to drive down the cost of capital to levels that are commensurate with the lower global cost of labour and maintain these lower levels for a significant period of time in order to provide the incentive for capitalism's animal spirits to create the new industries to absorb the additional labour force. The death of deflation has been greatly exaggerated. The decline of inflation from its early eighties peak has been responsible for the outperformance of government bonds over this period. Government bonds are unlikely to outperform risk asset over the next three decades, but we continue to believe that deflation is a clear risk over the next three years and that government bonds will outperform over this period. The forwards rate process shows the current estimation of the future price of money. In our view the future price of money is too high to produce inflation or sustained growth. This future price (forward yield) has to fall in order to stimulate necessary investment. This requires the risk free curve to be both lower and flatter over the next few years.